REQUIRED READING: With the bursting of the U.S. housing market bubble, a number of formerly little-considered terms in a typical mortgage have gained more prominence and emerged as significant factors that lenders must consider as they work to adapt to evolving logistical, legislative and financial realities.
One such issue, force-placed insurance, is an example of a relatively routine and obscure provision that has become increasingly relevant. An issue that resonates with homeowners, lenders and servicers alike, force-placed insurance is emblematic of how subtle features on the lending landscape can be brought into sharp focus when larger issues impact the industry.
The lender's right to force-place insurance arises from the mortgage documents, which contain provisions that stipulate that the homeowner agrees to carry sufficient property and casualty insurance so that the mortgagor's interests are adequately protected. Because it is mandatory to have insurance when there is a mortgage on the property, the lender is not only motivated by self-interest, but also legally compelled to initiate a policy if the borrower's policy lapses or is insufficient.
Typically, a force-placed policy (FPP) is purchased when there is no coverage (in the event of a foreclosure, for example) or when a homeowner's coverage lapses, whether due to nonpayment of premiums or other reasons. Once any grace period has expired, the lender is notified that the homeowner's insurance policy has lapsed. The lender will secure an FPP on the property and, in most cases, will add the monthly cost of this often-expensive new policy to the homeowner's mortgage payment.
Additionally, in some cases, an FPP may be implemented when there is a dispute regarding the amount or the type of coverage needed. An example could be in the event of a dispute over whether or not flood insurance is needed. Because an FPP is intended to protect the financial interests of the lender in the property, borrowers could find themselves in a disadvantageous position, believing themselves to be fully insured when, in fact, they are lacking the level of liability insurance required to protect themselves and their personal property, and potentially exposed to significantly higher insurance payments when the lender subsequently seeks reimbursement for its expenditure.
Unlike with traditional policies, which go through the standard underwriting process, based on an inspection and review of the particular property to be insured and the outlining of specific terms and conditions with regard to location, value and other factors, the FPP insurance market does not engage in standard underwriting. In fact, in many instances, servicers will have standing FPP treaty agreements with an insurer to provide for blanket coverage of a servicer's inventory of properties in case any suffer a lapse in insurance. As a result, these policies tend to be significantly more expensive, and servicers will pass the cost of the premium for this insurance along to the debtors.
Another obvious difference between FPPs and standard homeowner insurance policies is that, in the former, the insured party is designated to be the lender instead of the homeowner, and the amount covered under the policy will in many cases be the amount remaining on the mortgage, not the total amount of the property value. In addition, the FPP will not provide other coverage that is typically included in a homeowner's policy. For example, a lender-placed policy will not provide homeowner's liability coverage, which provides for the defense and indemnification of the homeowner against lawsuits from third parties. Such policies will also not provide coverage for a homeowner's personal property.Â
Market rates for FPPs are fairly standard and agreed upon, but the lack of underwriting creates many other variables and moving parts that must be taken into consideration. As a result, the precise language of the policy and the specific rights and responsibilities outlined in the mortgage documents carry increased weight when it comes to evaluating the mechanics of how the terms of an FPP are implemented and the resolution of any potential conflicts.
Thorny questions
Because mortgages, policies and legislative obligations differ from state to state, and because the FPP is a unique insurance product with its own somewhat idiosyncratic niche within the industry, there is plenty of room for interpretation and, unfortunately, misunderstanding and confusion. FPPs raise complex issues pertaining to the rights and responsibilities of lenders and borrowers to the law and to each other, the amount of insurance that is sufficient to cover exposures and, ultimately, to what degree lenders are obliged to account for and accommodate borrowers' interests when it comes to dispensing payment in the event of a claim.
To that end, some states, such as Connecticut, have specific legislation governing what can and cannot be done with FPPs. Taking the Nutmeg State as an example, some states allow for the issuance of so-called "dual interest" policies, which provide protection for both the lender and the borrower. The scope of such policies is still limited to the property interest but does allow for recovery of 100% of the replacement value of the property, with the borrower being entitled to any remainder after the primary payee – the lender – is satisfied.
Although poor communication among lenders, servicers and property owners is always a potential pitfall, the unique context of FPPs serves to heighten the dangers of unclear communication among the parties, not least in introducing a new party – the insurer – into the mix. Because it is typical that a homeowner's insurance premium is paid out of the escrow account, miscommunication between the homeowner and the servicer that leads to the nonpayment of premium and installation of an FPP has been the subject of litigation.
Even in cases where there is no dispute as to the borrower's lapse of coverage, litigation can ensue regarding the manner in which FPP coverage is procured. In the U.S. District Court for the Northern District of California, for example, a homeowner successfully maintained a putative class-action suit against an FPP insurer for breach of California's unfair trade law for agreeing with the lender to write an FPP that included within its policy period two months during which the prior property insurance policy allegedly provided coverage to the lender after nonpayment of the premium.
Additional concerns regarding a servicer's instituting of FPP coverage include whether an FPP is procured with insufficient limits to protect the borrower from a deficiency judgment, or whether particular coverage (e.g., flood insurance) is required. When an incident that triggers coverage under the FPP occurs, further disputes can arise with property owners disagreeing with the property valuation, and sloppy handling of a claim. All of these issues, both before or after a trigger of FPP coverage, may expose lenders to potential liability with respect to borrowers.
Adding to the confusion is a lack of consistency. These inconsistencies have created somewhat of a legal gray zone with respect to many aspects of FPPs, particularly the dual-interest policies that seem to provide at least some coverage of the borrower's interest. Decisions issued in bankruptcy cases in 2006 and 2007 in Pennsylvania illustrate this dynamic all too clearly.
In 2006, the U.S. Third Circuit Court of Appeals ruled that because the FPP represents a contract between the lender and the insurer, there is no requirement to inform or involve the property owner in the course of adjusting a claim. However, in 2007, a bankruptcy court in the Western District of Pennsylvania reached almost the precise opposite conclusion. In a case where a claim was made on a dual-interest FPP and payment was issued, the lender kept its portion and deposited the remainder into an escrow account for the borrower.
When a dispute arose over the amount of payment, the court held that the lender failed to adequately inform the borrower and that ultimately, it is the lender's duty to maintain clear and consistent lines of communication and to ensure that the property owner's interests are protected.
An evolving landscape
The high-profile media coverage devoted to the increase in the number of foreclosures in recent years has helped prompt a relatively robust legislative response to broader economic uncertainties, and the subsequent changes to the legislative landscape promise to have a potentially profound impact on a number of financial regulatory issues. As with many issues connected to lending, home and commercial mortgages and foreclosure-related financial regulation, as well as the mechanics and application of FPPs, have emerged as a relatively hot topics, and legislative changes in recent months have directly addressed FPPs.
On the federal level, the most significant recent development impacting FPPs has been the Dodd-Frank Wall Street Reform and Consumer Protection Act. Among the many provisions related to financial services regulation in the Dodd-Frank Act, which was signed into law July 21, 2010, are a number of amendments to the Real Estate Settlement Procedures Act of 1974.
Some of those amendments, located in Section 1463 of the Dodd-Frank Act, establish stringent new notification rules and limitations regarding FPPs obtained for any federally related mortgage.
Specifically, the legislation mandates that a servicer "not be construed as having a reasonable basis for obtaining force-placed insurance" unless:
- Written notice is sent to the borrowers that reminds them of their hazard-insurance obligations, states that the servicer currently does not have evidence of such insurance, states in a "clear and conspicuous" manner the procedures by which borrowers can demonstrate the existence of such insurance, and provides a warning that the servicer can obtain such insurance at the borrowers' expense if no such proof is provided;
- A subsequent written notice is sent at least 30 days after the initial communication, containing the same information as the previous notice; and
- Fifteen additional days pass after this second notice is sent to the borrower.
Only after these prerequisites are met can an FPP take effect at the borrower's expense. Another – and potentially more ambiguous – change is the implementation of legislative language stating that lenders and servicers "shall accept any reasonable form of written confirmation from a borrower of existing insurance coverage."Â
While the long-term implications remain uncertain, the impact of these new legislative guidelines will be felt immediately. The 45-day window obviously raises a number of questions. Lenders must now decide how to protect their interests during this federally mandated "lag time." During this 45-day window in which the property is exposed, lenders will now have to choose between two less-than-ideal options: obtain an FPP themselves at their cost or leave the property unsecured.
Alternatively, lenders may avail themselves of a third option: to foreclose on the properties and thereby bring the risk under control. The language of the Dodd-Frank Act does not change the fact that a failure to maintain insurance is an incident of default under the mortgage agreement, and the provisions described above apply only to the remedy of FPPs, not to foreclosure. Therefore, these provisions of the act may drive lenders away from the remedy of FPPs and toward the remedy of foreclosure, depending on their assessment of the risks and costs.
In addition, the imprecise language of the legislation regarding what constitutes proof of insurance on the part of the borrower raises the question of what, exactly, "reasonable" confirmation entails. The definition of what constitutes a "reasonable form of written confirmation" is unfortunately not provided by the act, and will likely be left to be clarified and interpreted by the courts.
For lenders and servicers, this uncertainty means that developing a consistent strategy going forward will be difficult; it is likely going to be hard to accurately judge risk and exposure until the industry gets some additional clarification from established case law. In the meantime, servicers would be wise to try to strike an effective balance between aggressive and conservative practices, staying informed and keeping a close eye on how the inevitable pushback to this new legislation plays out in the courts.
The bottom line is that FPPs have become a more significant presence in the industry, particularly as increasing foreclosures result in many properties' being devoid of traditional property coverage. Servicers and lenders would be wise to familiarize themselves with the mechanics and nuances of their FPPs and take steps to maintain best practices that ensure that FPPs are applied in the proper situations, limits are sufficient and the interests of all parties are adequately covered as required by the relevant jurisdiction.
When the occasion comes for a claim under an FPP, the servicer should be careful to make sure that accurate and complete communications are being made to the borrower to inform them of the nature of the claim, the nature of the FPP, the insurer and whom the borrower can contact in the event of a dispute. FPPs, although an important tool to ensure that lenders' interests are protected as fully as possible, can expose lenders to higher exposure or liability than would exist in the course of a claim under a standard property insurance scenario, and the key to limiting that exposure and minimizing risk is to focus on ensuring accurate notice and communication with borrowers – both at the time of instituting an FPP and in the event of a claim.
Lenders that are able to remain open, accurate and communicative with property owners can not only avoid unnecessary and costly misunderstandings and disagreements, but also may be able to remove themselves from the equation entirely in the event of an appraisal dispute between the owner and the insurer.
It goes without saying that lenders and mortgage companies should keep abreast of state-specific statutes, be keenly aware of the language in every FPP, and understand what the implications are in terms of rights and responsibilities for all parties. Responsible lenders should engage insurers and make certain that all parties are on the same page regarding those obligations. Lenders that can successfully do so will likely find themselves ahead of the curve with regard to an insurance product that seems likely to continue to feature prominently in an evolving marketplace.
Mario Borelli is an attorney at Hartford, Conn.-based Hunt Leibert Jacobson PC, a firm that provides legal representation in finance, foreclosure, bankruptcy and mortgage related litigation in both state and federal courts. Borelli can be reached at (860) 241-2822 or mborelli@huntleibert.com.
